Is it wise to borrow from a related party?

By: Jackie Lou Chua

WHEN operating a company, capitalization and working funds are needed for it to run properly and efficiently. One way of getting this necessary funding is through borrowings. Normally, a company will borrow from banks or any financial institution that is willing to lend, provided certain qualifications or collaterals are offered. This route, however, may take a while to get approved.

As an alternative, a company can opt to borrow from related parties that are willing to lend under more convenient circumstances, that is, without requiring collaterals or qualifications guaranteeing the company's ability to pay. These lenders instead rely on the related party relationship as assurance that the company will pay them back.

The question now is: Can interest expense be claimed as a deduction from gross income, and what are the requirements for the same to be considered deductible?

Based on the recent issuance of Revenue Memorandum Circular (RMC) 19-2024, under Section III. A1, interest paid or incurred within a taxable year on indebtedness in connection with the taxpayer's profession, trade, or business shall be allowed as a deduction from gross income, subject to certain limitations, when the following requisites, provided in Section 34(B)(2) of the National Internal Revenue Code (NIRC) of 1997, as amended, and as implemented by Revenue Regulation (RR) 13-2000 and Section 7(B) of RR 5-2-21, are met:

• the indebtedness must be that of the taxpayer;
• the interest must have been stipulated in writing;
• the interest must be legally due;
• the interest payment arrangement must not be between related taxpayers as mandated in Sec.34(B)(2)(b), in relation to Sec. 36(B), both of the NIRC of 1997, as amended;
• the interest must not be incurred to finance petroleum operations;
• the interest was not treated as "capital expenditure" if such interest was incurred in acquiring property used in trade, business, or exercise of profession; and
• the interest will be reduced by an amount equivalent to 20 percent of interest income subject to final tax; however, if the final withholding tax rate on interest income of 20 percent will be adjusted in the future, the interest reduction will be adjusted accordingly.

In addition, the taxpayer must have withheld the appropriate tax to claim the interest expense as deduction from gross income. Further, the same RMC also provides that interest expense paid on intercompany loans will not be deductible from gross income if both the taxpayer and the person to whom the payment has been made are persons specified under Section 36(B) of the NIRC of 1997, as amended.

Section 36(B) reads as follows: "(B) Losses from Sales or Exchanges of Property. – In computing net income, no deductions shall in any case be allowed in respect of losses from sales or exchanges of property directly or indirectly... (1) Between members of a family. For purposes of this paragraph, the family of an individual shall include only his brothers and sisters (whether by the whole or half-blood), spouse, ancestors, and lineal descendants...."

Based also on RR 19-2020, in determining whether a person or entity is a related party, the following will apply: A person or a close member of that person's family is related to a reporting entity if that person has control or joint control of the reporting entity, has significant influence over the reporting entity or is a member of the key management personnel of the reporting entity or of a parent of the reporting entity.

An entity is related to a reporting entity if any of the following conditions apply:

• The entity and the reporting entity are members of the same group, which means that each parent, subsidiary, and fellow subsidiary is related to the others.
• One entity is an associate or joint venture of the other entity or an associate or joint venture of a member of a group of which the other entity is a member.
• Both entities are joint ventures of the same third party.
• One entity is a joint venture of a third entity, and the other entity is an associate of the third entity.
• The entity is a post-employment benefit plan for the benefit of employees of either the reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a plan, the sponsoring employers are also related to the reporting entity.
• The entity is controlled or jointly controlled by a person identified.
• A person identified has significant influence over the entity or is a member of the key management personnel of the entity (or of a parent of the entity).
• The entity, or any member of a group of which it is a part, provides key management personnel services to the reporting entity or to the parent of the reporting entity.

In all cases, the substance of relationships between entities shall be taken into account and not merely the legal form.

With the above clarifications, borrowings from a related party will not be considered deductible for purposes of income tax calculation even if all other requisites are met and even if corresponding withholding taxes are remitted to the tax office.

Although it is easier to borrow from a related party, it comes at a price: not being able to deduct the corresponding interest expense for purposes of income tax calculation. Hence, taxpayers should carefully consider their options when the need to borrow arises. For all its requirements and scrutiny, perhaps borrowing from banks and other financial institutions is the smarter move compared to knocking on the door of a related party.

As published in The Manila Times on 4 March 2024. The author is a Senior Manager with the Tax & Corporate Services division of Deloitte Philippines.